The municipal bond tax loophole — low-hanging fiscal fruit

Peter Schweizer proposes a tax increase that will raise $124.4 billion over the next ten years. He wants to eliminate the tax-exempt interest on municipal bonds for upper income Americans and, with respect to newly issued municipal bonds, eliminate it for all Americans regardless of income. According to Schweitzer, this move would produce $124.4 billion over the next ten years.

Not surprisingly, President Obama has already proposed limiting or ending the tax-exempt interest on municipal bonds for the “rich.” But Schweitzer argues that this is one tax hike that conservatives should embrace, for two reasons.

First, in the current low interest rate environment, the tax exemption makes borrowing money cheap, thereby encouraging debt. State and local government debt doubled over the last ten years, rising from $1.4 trillion in 2002 to $3 trillion in 2011. “Shrink the incentive to bankroll big spending,” says Schweitzer, “and you shrink the size of government.”

To be sure, state and local governments use bonds to raise money for essential services that no one should want to “shrink.” But they also use bonds to finance non-essential, corporate enterprises. This leads to Schweizer’s second point — that taxing interest on bonds would strke a blow against crony capitalism.

The problem, according to Schweizer, is that “when local governments pick winners and losers, they force others to compete with government-funded cronies financed at lower rates.” For example, the Kansas STAR (Sales Tax Anticipation Revenue) bonds program funneled sales taxes to developers to build things like the Kansas Speedway and to finance the Heartland Park Racetrack in Topeka. And Bloomberg News recently estimated that tax exemptions on interest paid by municipal bonds for sports structures rob roughly $146 million a year from the U.S. Treasury. As Schweitzer observes, “in a time of serious deficits, this hardly seems wise.”

JOHN adds: I agree. Many people fail to understand that the purpose of the exemption for state and municipal bond interest is not to help rich people–the only ones who buy such bonds–but rather to lower the borrowing costs of state and local governments. If a normal interest rate were 6%, the municipal bond rate might be, say, 3.5%, or whatever number is equal to the after-tax rate for a taxpayer in the highest marginal income tax bracket. Wealthy bond-buyers break even on the deal; it is the governmental units that benefit. So eliminating the deduction will benefit the federal government while costing state and local governments more money–a cost they can avoid by borrowing and spending less.